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THE STORY 

OF 

MONETARY 
POLICY 








II I? i! ! 




Awhile later, after interest rales had 

risen further, members of the construction 

industry demonstrated their unhappiness 

by sending some two-by-fours to the 

Federal Reserve Board. 




I hope the cement 

industry doesn't get 

angry at the Fed. 




What the farmers and the butlders were protesting was the Federal 
Reserve's monetary policy. But what ts monetary policy, anyway? 




The term "money" refers Co cash in circulation and Che amounts that 

people and businesses have in bank accounCs, and "credic" means Che 

amounts that banks and other lenders can lend. 




We expect the economy to perform in certain 

ways — ways that are influenced by what 

happens to money and credit. For example, 

we expect the economy to grow, so that we 

can enjoy a rising standard of living. 




In other words, we want the economy to provide an 

Increasing amount of aoods and services for each American 

to enjoy. Economists call that rising "real GDP per 

apita." The phrase "per capita" means "oer oersnn." 



cap 



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REAL GDP PER CAPfTA 




"GDP" stands for gross domestic product, the dollar value of the 
nation's output of goods and services. Over time, GDP rises for 
two reasons — one is that the economy's output increases, 
and the other is that prices rise. 



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REAL AND ^OMI^AL GDP 




!♦»♦ im mi iw SBS an mtiSS mm mm 



"Real" GDP data eliminate the effects of the price 
increase and thus show only the changes in actual output. 



We want the economy to grow, not only to 

give us a rising standard of livmg, but also 

to provide jobs for people who enter the 

labor force each year. 



Growth is one of our economic ioals. Another is price stability. We 

want to avoid an inflationary economy — where you have a sustainec 

and rapid increase in the price level. 




Inflation is undesirable for several 

reasons. One is that inflation is 

unfair and maizes some people worse 

off because their incomes don't 

rise as rapidly as prices. 




Inflation also hurts people who lend money at interest 
rates that are lower than tlie rate of inflation. 




Another way in which inflation hurts is by making 
It harder for businesses to plan. 



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Inflation sometimes feeds on itself; one set 
of price increases lead; to another. 



If unchecked, Inflation can lead to hyperinflation, 
in which prices rise extremely rapidly. 




Hyperinflation has occurred a number 

of times — for example in Hungary after 

World War II, Argentina in the 

19B0's and Brazil In the 1990s. Some 

episodes of hyperinflation 

have led to great social unrest. 



Money and credit must grow 

at a pace that allows 
economic activity to expand 
at a sustainable rate without 
excessive price increases. 



If money and credit grow too slowly, 

people and businesses will not be 

able to get the loans they need for 

new homes and equipment. 



Id really like to 
expand my business, but 
I can't afford to pay the higher 
interest rates you're charging 
during this period of stow 
money growth. 




The lack of funds for loans will, in turn, lead 

to stow growth in the economy, or even to 

recession — a period in which the output of 

the economy actually declines. 



The rise in unemployment that occurs during a 
recession brings hardship to many people. 




If money and credit increase too 
rapidly, the result will be inflation. 




The responsibility for making sure that the nations 

money supply grows at the appropriate rate lies with 

the nation's central bank, the Federal (Reserve. 




^ 



There are several different parts of the Federal Reserve System ("the Fed" For sfiort), and they play 

different roles in determining and carrying out monetary policy. The Fed is headed by the Board of 

Governors in Washington, D.C. The seven governors are appointed to 14-year terms by the President 

of the United States with the approval of the U.S. Senate. 





One governor's term expires at the end of January 
each even- numbered year. The scheduling makes 
it unlikely that any U.S. president would appoint a 

majority of the seven Fed governors in one term. Of 
course, if a governor resigns before the end of a term, 

the president gets lo make an interim appointment. 



The staggered 14-year terms help insulate the 

Fed from day-to-day political pressures. Unlike most 

other government officials, the members of the 

Federal Reserve Board, including the chairman, 

keep their jobs when a new U.S. president comes 

into office, and they can't be fired because of 

policy differences with the president. 




Another factor chat insulates the Fed from political pressure is its nonrellance on 

appropriations from Congress. The Federal Reserve's income consists mainly of the interest 

that it receives on its large holdings of U.S. government securities. 




It's important for the Fed to be free of short-term 
political pressure as it fights inflation. Indeed, 

some research shows that the more independence 

a nation's central bank has, the more success 

the country has in avoiding inflation. 




The reason that a central bank needs independence is 

that fightina inflation requires actions that limit the 

grov^th of money and credit, and those actions 

may cause some temporary — but unpopular — business 

slowdowns and unemployment in the economy. 





White the Fed's 

decision making is 

Independent, the head 

of the Federal Reserve 

Is required by law to 

present testimony 

explaining the Fed's 

monetary policy plans 

to Congress twice a 

year. Congress invites 

the chairman to testify 

at other times, too. 




In addition to the Board 

o( Governors, the Federal 

Reserve System also consists 

of Federal Reserve 
Banks around the country. 




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The seven memt>ers of the Board of 

Governors and the presidents of 

five Reserve Banks are the voting 

members of the Federal Open Market 

Committee (FOMC). The FOMC meets in 

Washington, D.C, eight llmesa 

year, to determine the course of 

monetary policy. 



The president of the 

Federal Reserve Bank 

of New York is always a 

voting member and serves 

as vice chairman of the 

committee, while the 

presidents of the other 

Reserve Sanfis serve 

one-year terms on a 

rotating basis. 




Before reaching its decision, the FOMC 

studies a v/ide variety of economic and 

financial data. The committee has to 

consider, for example, how rapidly the 

economy is growing and whether Inflation 

appears to be a problem. 



The committee also considers the 

analyses that the Federal Reserve 

Banks prepare reporting 

on economic conditions within 

their districts. 



After reaching a decision on what 
monetary policy to pursue, the FOMC 

sends instructions to the domestic 

money market desk ("the desk') at the 

Federal Reserve Bank of New York, 

which has the responsibility for 

executing the FOMCs policy. 



The FOMCs tnstnjctions include 

a target for the federal funds 

rate, the interest rate banks 

charge one another on short -term 

loans of excess reserves. 




The desk works to keep the federal funds rate at, or 

near, the FOMCs target by buying and selling U.S. 

government securities, which are lOU's of the federal 

government, and certain other types of securities. The 

desk conducts these transactions electronically. 



The desk's transactions take place with a number of 
securities firms that are designated as primary dealers. 

These are securities dealers authorized by 

the Fed to engage in transactions with the desk. How 

does the Fed flecide which primary dealers to buy 

securities from or sell to on a particular day? 



When the Fed wanis to buy securities, It asks the 

primary dealers which securities they choose to sell to 

the Fed. The desk Chen selects Chose securities that 

best meet its needs for chat day. 





The Fed's buying and selling of securities is 

known as "open market operations." The term 

■'open market" means Chat Che Fed decides which 

securities dealers it wilt do business wich on a 

parCicutar day. The choice emerges ffom the 

"open market" in which dealers compete on the 

basis of price and other characteristics of the 

securities they buy and sell. 



DEALER 




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FED/ 




11 



Open market operations are intended mainly to 

offset fluctuations in ban!* reserves that result 

from seasonal or other technical factors. 



If the Fed didn't counteract these influences, short 

lived, but undesirable, changes in short-term interest 

rates might result. One such influence might be a 

change in the amount of casli people want to hold. 




The amount of cash that Che public holds is 

not constant. It increases, for example, during 

busy shopping seasons. 




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When people withdraw cash from banl<s — to go 

shopping, for example — bani(s' reserves and the 

amounts they can lend decline. 



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If the Fed didn't act to 
offset the decline by buying 

securities and thereby 

adding reserves to the 
banltjng system, the result 
could be a drop in money 

and credit and a rise in 

interest rates that could 

curtail economic activities. 




The Fed does act, though, during the times of the year when bank reserves are low. During those times, the Fed 

often buys securities to boost bank reserves. When reserves are unusually high, the Fed often sells securities to 

temporarily absorb, or drain, some reserves from the banking system. Thus, the Fed tries to keep bank reserves, 

money and credit, and the economy on a smooth and appropriate path. 




The Fed was especially busy buying securities tn 

late 1999, when people took a lot of cash out 

of banks because of worries about possible 

bank computer problems In January 2000. 




In addition to open market ooe rations. 


the Fed has two other major 


monetary policy tools: reserve 


require 
TO 


ments and the discount rate. 


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Reserve requirements are the portion of deposits that banks have to keep either on hand or on 

deposit at a Federal Reserve Bank. For example, if the reserve requirement is 10*, a bank that 

receives a S100 deposit may lend %'}0 of that S100, but it may not lend the other $10. 




Whoever borrows the S90 is likely to pay someone who wilt deposit the S90 in another bank. That bank in 
turn, can lend VOX of S90, or S81. Then the bank that gets the S81 deposit can lend 90* of S81 , or 572.90. 




Through this process, the banking system creates money; the level 

of reserve requirements influences how much money banks can 

create. The higher the reserve requirements, the greater the 

restraint on bank lending. If, for example, the reserve requirement 

were US, the banks receiving the S100 deposit could lend only S86. 

and the bank receiving the SB6 deposit could Send only S73.96. 



|100iW 

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10% RESERVE 
RFOLIIREMENT 



The Monetary Control Act of 1980 authorizes 

the Fed's Board of Governors to set reserve 

requirements no lower than B% and no higher 

that 14% on chectiing accounts. 



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In April 1992, the Fed cut the requirement from 
12* to 10*. Why do you think the Fed did that? 



One reason, according to the Fed, was to put 
banks "in a better position to extend credit." 




Changes In reserve requirements are infrequent, 

though. As of 2006, some 14 years had gone by 

without a change. 




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We weren't even 

born yet the last timel 

reserve requirements j 

were changed. 



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One reason they are infrequent is that reserve 

requirements impose a cost, which is like an added 

tax on banks —a cost that other types of financial 

firms do not have to bear. 



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The third tool of monetary 

policy is the discount rate, 

the interest rate at which 

Federal Reserve Banlts make 

very short-term loans to 

banks. Banks can borrow 

from the Fed for any reason. 



The rate charged by the Fed 
is higher than the federal 
funds rale, so banks typi- 
cally prefer to borrow from 
one another whenever it is 
prudent to do so. 



I I 

An increase In the discount rate is seen as evidence of the Fed's aim to slow the pace of 

economic activity — perhaps in order to prevent Inflation. A decrease in the discount 

rate is regarded as evidence of the Fed's aim to stimulate the pace of economic activity. 



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For example, toward the middle of 2005, the FOMC raised the discount rate repeatedly 

in small steps. These increases removed some of the potential for future inflation 

caused by very low interest rates stimulating the economy unnecessarily. 



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DISCOUNT RATE 



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17 



By using open market operations, reserve requirements and the discount rate, the 
Fed influences the cost and availability of money and credit in the economy. 




Over the years, changes in the relationship between the money supply and the economy have complicated the Fed s job 
of formulating monetary policy. For many years, changes ir the economy were closely related to changes in a money 
supply measure called Ml , which consists of currency in circulation and checking accounts at depository institutions. 



CLOSE RELATIONSHIP BETWEEN M1 AND OUTPUT 




In the 1980s, though, when banks started paying Interest on checking accounts, 

people put a lot more money into checking accounts. As a result of the rapid growth 

in M1 , the relatfonshtp between M1 and the economy broke down. 



PERCENT GROWTH 
30 



2S 



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-10 



I960 1965 1970 1975 1980 1985 1990 1995 2000 



2009 



Similarly, the relationship between M2 (a broader measure that includes savins accounts as well as 

M1 ) and the economy broke down in the early 1 990s, when Interest rates were Tow. During this time, 

people pulled money out of saving accounts and put it Into financial investments outside of banks — 

in investments such as mutual funds that are not included in the money supply. 





/^ At least for the 
/ time being, M2 has been ' 
I downgraded as a reliable 
\ indicator of financial 
\ conditions in the 
St/\^^ economy. 




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The Fed does, however, pay attention to a 

large variety of economic and financial data in 

making Its monetary policy decisions. 



For example, the Fed considers changes in 

employment in the United States, as well as 

movements in the unemployment rate, which 

tells us the percentage of the people in the 

country who want jobs but don't have one. 





The unemployment rate is related to the build-up of 

Inflationary pressures. For example, when 

unemployment Is low and firms want to expand 

production, they may not find the key people they need 

at current wage levels. Instead, they may have to pay 

their own workers higher overtime pay or offer wages 

high enough to aitract workers from other firms. 



The Fed also looks at a 

variety of inflation 

measures, including the 

consumer price index 

(CPi), which measures 

changes in the prices 

that consumers pay for 

things tike food, 

clothing, rent and 

entertainment. 




Sometimes, chanHes ui the prices of commodities, such as lumber and copper, that are 
used in the production of many other items can provide early warnings of inflation. ' 



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international considerations complicate the making 

of monetary policy. In particular, international forces. 

Including policies of other countries, can have substantial 

effects on the dollar e«change rate and U.S. interest rates. 



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In recent years, international trade and international 
financial activity, such as U.S. bank lending abroad, 
have grown rapidly. As a result, the Fed has to be 

concerned about the value of the dollar, as measured 
in terms of foreign currencies. 




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21 



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When the dollar is strong, 

Americans find foreign goods 

cheaper to import. 



American goods are more expensive, though, so foreigners may 

buy fewer of them, reducing U.S. exports and jobs. When the 

dollar is weaker, foreigners find U.S. goods cheaper to import, 

so U.S. industries can export more. 




A weak dollar can aggravate 

inflationary pressures in the 

United States. 




Interest rates are one factor affecting the value of 

the dollar. For example, when interest rates are 

higher in the United States than elsewhere, foreigners 

want to invest their funds here in order to earn a 

higher rate of return. The increased demand for U.S. 

bonds pushes up the value of the dollar. 




I 



Making monetary poiicy is a complicated job, 

but it's a job that s necessary in order for our 

economy to enjoy continued growth along 

with stable prices. 





"The Story of Monetary Policy" uses non- 
technical language and lively Illustrations 
to explain: 

■ the meaning and purpose of 
monetary policy, 

■ how the Federal Reserve makes 
monetary policy, 

■ what factors the Fed considers in 
making monetary policy, 

■ the tools of monetary policy — 
open market operations, reserve 
requirements, and the discount 
rate — and how they work. 

For more information about 

New York Fed education 

prograrr)s, visit: 

www.newyorkfed.org/education 



Federal Reserve Bank of New York 

Public Affairs Department 

33 Liberty Street 

NewYork, NY 10045 

(212) 720-6134 

NOT FOR RESALE 

For free copies, visib 

www.newyorkfed.org/publications 



Reprinted 
2006